I have had several friends discuss the following question with me recently. Can the US economy undergo a sustained recovery without any participation from residential real estate? Moreover, they have forwarded to me several blogs such as the Diary of a Mad Hedge Fund Trader that point to a chart that prices US residential real estate in gold for the last 40 years. Many of these chartists suggest that residential real estate prices have another 10 to 15% to fall relative to gold before they can grind sideways or head slowly upwards. I imagine the gold bugs among them have concluded that if gold falls in price, the US financial system is doomed as all assets tumble in value and anyone who has a mortgage falls further underwater….
Real estate may fall another 10 to 15% relative to gold, but I don’t know how these traders can foresee this future from the chart. These bloggers contend that gold is the only real store of value and is therefore the “real” benchmark to use in determining where real estate prices are headed. If you look at the data since 1970, however, for median and average nominal sales prices of new homes sold in the US and real home prices as calculated by Robert Shiller, expecting a return to relative values of the early 1980s is not clear. If we examine the data, we see that Pearson’s Correlation Coefficient is positive and fairly strong for nominal real estate sales prices and gold, but only slightly positive and weak for real home prices and gold. (r=0.67 and 0.34 respectively)
These relationships between real estate and gold make a lot of sense to me. Generally, if the prices of hard assets are going up or down on a nominal basis, it makes sense that they will move in the same direction. But the factors that are driving the long-term, positive, real, upward trend in the prices of real estate are not necessarily the same ones that are driving the more idiosyncratic values of gold. Moreover, the price of gold in the US was an artificial one until the 1970s. On the one hand, a house can be a pain to take care of, but you have to live somewhere; on the other hand, gold is cool and shiny and always worth something across history, but you have to make sure that no one steals it from you.
So back to the original question rephrased: are all US citizens going to rent property and hoard gold and watch the real estate market collapse? If so, what does this mean for the US economy? Well, I would not completely give up on the American dream just yet, but even a cursory review of jobs reports makes one conclude that it will be very difficult for the economy to recover without real estate making at least a partial comeback and it is probably going to be a while before it does. According to the Bureau of Labor Statistics 7.4 million jobs, or 5.1 percent of total employees, counted on residential real estate for work at the peak of the real estate cycle in 2005. As the housing market crashed, residential-construction-related employment fell substantially; jobs in the industry fell to 4.5 million in 2008, accounting for only 3.0 percent of total U.S. jobs. At its current pace, it will take quite some time for the private sector to create sufficient jobs to make up for the shortfall in the real estate and construction industries. Sad, but true – no matter how rosy a spin you want to put on the data or the outlook….
The US real estate problem is demographics. Demography is destiny. I am certainly not the first person to note that relationship. (That line is usually attributed to Auguste Comte). But it certainly is one of the forces that will drive real estate sales and prices (and therefore construction and jobs) in the United States over the coming years. I think it is far more important than the price of gold! Demographics is also a major force behind my vision of the emerging market consumer that is going to be one of the worldwide economic drivers of at least the next decade or two.
The aging of the Baby Boom generation (roughly 76 million individuals) here in the US is the demographic trend that is currently having and will have the greatest impact on the real estate market in the medium term until Generation Y or the Millennials can afford the Baby Boomers’ homes. Generation X alone does not have sufficient numbers to buy the homes will come onto the market. This is another compelling argument for greater H-1B visa and other legal immigration into the US. Baby Boomers born just after WWII are currently entering the time of their lives (65+) when they downsize their homes and either move back into city centers to be closer to good medical facilities and entertainment options or into retirement/semi-retirement/vacation areas. They are slowly unloading their homes and settling into condos and other properties that are easier to take care of. Ebay, Craigslist and other companies benefit from this trend as Boomers find new homes for their old “stuff.”
Although mortgage rates will most certainly increase at some point in the next year or two, I do not believe that any initial increase will have much of an impact at all upon prices or demand for residential real estate and it may even be a net positive for the market. I realize this sounds like economic heresy. When the cost of acquiring an item rises, demand for it decreases, right? This is certainly the case for most items with a price that is elastic. I’d make that bet 99% of the time.
There are certain items for which this relationship between price and demand does not always hold true, however. For example, when stocks rise in price, momentum investors and many individual buyers want to climb aboard “winning stories.” Similarly, people like to buy homes when they are increasing in value believing that they will continue to do so. They don’t like to purchase when prices have been cut or when they are declining thinking that this too shall continue. Therefore, demand often rises as prices rise and this demand comes not only from speculators. Prices and interest/mortgage rates often need to rise quite substantially to choke off demand once demand begins to rise. Indeed, historically, there has been no correlation (it is slightly negative) between the market yield on the 10 year treasury security (which drives mortgage rates) and median nominal sales prices of new homes sold in the United States and real home prices as calculated by Robert Shiller (r=-0.36 and -0.28 respectively). There does appear to be a very long term and very high correlation between median nominal home prices and population growth, however. (r=0.98) Demographics matter.
Demographics matter over the long term, but can they guide us in the short and medium term? Unfortunately, not quite so much. But they explain a good deal more than interest rates or gold. For example, a strategy of keeping interest rates low to keep mortgage rates low to encourage home buyers to buy because home prices are held lower is not one that appears to be based on a sound analysis of historical data. Such a strategy will not work for the long term. A more effective strategy would be to encourage legal immigration to the US and to promote and encourage population growth and new household formation. I hope it is not a generation before we see any real return on residential real estate although this could be the case unless the US decides to adopt more open legal immigration policies. As you can see from the chart above, unless building costs are rising, it can take a very long time to see any real return on one’s investment in housing!
Without a sufficient ROI in residential real estate, it is hard to envision a revival of the construction industry which is important engine of job growth for the economy. This is another reason why I believe Fed Chairman Ben Bernanke is pushing for a more explicit inflation target. With an explicit target, there is no more guessing about objectives and it would help generate at least a nominal return on some residential real estate investment and put some Americans back to work. Only then can we breathe a bit easier about a sustained economic recovery.
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